Corporate Office Properties Trust

F:WX7

Earnings Call Analysis

Company Raises FFO and NOI Guidance After Strong Q2

In the second quarter, the company outperformed expectations, with funds from operations (FFO) per share at $0.60, $0.02 above midpoint guidance, driven by lower-than-expected operating expenses and interest costs. Leasing activity was robust, led by a 96.8% lease rate in the Defense/IT segment, and same property cash net operating income (NOI) growth at 5.8% YOY. Guidance for same-property cash NOI has been raised 100 basis points, now ranging 4.5% to 5.5%, while cash rent spread forecasts are up 50 basis points, expected to be flat to 1%. The portfolio's solid performance and leasing commit to a strong trajectory for future NOI growth. With this, the company increased its FFO per share guidance midpoint for 2023, from $2.38 to $2.40, indicating FFO per share growth of 2% YOY.

Defense Investments and Stable Operations Propel Growth

The company has continued to deliver strong operating results and maintains a positive outlook for future growth. Notably, the Defense/IT segment's high-priority mission locations adjacent to defense contractors create significant competitive advantages, contributing to the highest industry retention rates. The boost to the Department of Defense budget has increased demand across their portfolio. Reflecting this, the second quarter FFO (Funds from Operations) per share exceeded expectations at $0.60, beating the guidance by $0.02. The core portfolio is robust, with an impressive 95% leased, marking a year-over-year increase and further underscoring strong portfolio performance.

Occupancy and Leasing Momentum

There's a noticeable increase in occupancy across the portfolio. With a strategic focus on the Defense/IT locations, which reported a record 96.8% leased rate, the company is seeing strong retention and vigorous leasing activities. Furthermore, the firm has executed significant vacancy leasing and remains on track to hit the full-year targets. The leasing efforts show resilience, with expansion plans in highly-concentrated defense locations auguring well for growth. Coupled with ongoing developments being 92% leased and a lucrative pipeline for future projects, this traction in leasing highlights the predictable and growing cash flows expected from the portfolio.

Robust Financial Position and Future Outlook

In a volatile capital market environment, the balance sheet remains strong. There are no significant debt maturities until 2026, manifesting the organization's sound financial management. They enjoy substantial liquidity with ample line of credit availability and a forecast to keep variable rate debt under 10% by year-end. The revised FFO per share guidance for 2023 represents a 2% growth from the previous year, indicating management's confidence in the company's earning potential and a consistent FFO growth expectation through 2026.

Elevating Cash NOI Guidance Amid Positive Performance

With stellar performance in the first half exceeding initial estimates, the company has raised the midpoint of its same-property cash NOI (Net Operating Income) guidance by 100 basis points, signaling a strong outlook for operational revenues. Additionally, cash rent spread guidance has been increased, your reflecting positive trends in rental income growth. These adjustments to financial forecasts underscore management's confidence in sustained operational excellence and profitability.

Positioned to Benefit from Cybersecurity and Government Investment

The company is strategically positioned to leverage the U.S. government's emphasis on cybersecurity, with a portfolio accommodating cyber activities. This has led to record levels of leased inventory and demands for secure, government-contracted spaces. The company's facilities, designed to support these critical missions, provide a stable and attractive proposition, indicating long-term benefits and expansion possibilities. In particular, the significant cyber leasing activities in their development and operating portfolios resonate with their prowess in a niche market that enjoys sustained government investment.

Payout Ratio Strategy Reflects Solid AFFO Improvement

The company aims for an AFFO payout ratio in the 70% range, with projections hinting at performance in the mid-60% range for the year. This strategy demonstrates management's prudent approach to dividends and capital allocation while ensuring corporate growth and shareholder returns are well balanced.

Earnings Call Transcript 2023-Q2

[Operator]

Welcome to the Corporate Office Properties Trust Quarter (sic) [ Second Quarter ] 2023 Results Conference Call. [Operator Instructions] As a reminder, today's call is being recorded.

At this time, I'd like to turn the call over to Venkat Kommineni, COPT's Vice President of Investor Relations. Mr. Kommineni, please go ahead.

[Venkat Kommineni, executive]

Thank you, Joanne. Good afternoon, and welcome to COPT's conference call to discuss second quarter results. With me today are Steve Budorick, President and CEO; and Anthony Mifsud, Executive Vice President and CFO.

Reconciliations of GAAP and non-GAAP financial measures that management discusses are available on our website in the results, press release and presentation and in our supplemental information package. As a reminder, forward-looking statements made during today's call are subject to risks and uncertainties, which are discussed in our SEC filings. Actual events and results can differ materially from these forward-looking statements, and the company does not undertake a duty to update them. Steve?

[Stephen E. Budorick, executive]

Good afternoon, and thank you for joining us. Our investment strategy and differentiated portfolio continue to generate strong operating results and support our positive outlook for our business for the coming years. The $100 billion increase to the Department of Defense budget that had been appropriated since March 2022. And the roughly $25 billion increase that is expected to occur later this year, has and will continue to drive strong demand throughout our Defense/IT portfolio. Our capital allocation decisions have deeply concentrated our assets in locations adjacent to or in some instances, containing high priority missions.

Defense contractors benefit greatly by locating offices proximate to these high priority missions. These missions require secure office environments and the mission work cannot be performed from home. The secure environments for these missions are difficult to get approval to construct, expensive to create and requiring significant tenant co-investment and are not transportable. These are the major factors that drive our industry-leading retention rates.

Accordingly, our competitive advantages of the best locations adjacent to these high-priority defense missions. A unique portfolio with significant security improvements, readily developable land sites to support mission growth, a 30-year track record of performance excellence and our franchise of relationships and security credentials continues to provide strong results, including resilient cash flows and FFO growth.

We reported second quarter FFO per share as adjusted for comparability of $0.60, $0.02 higher than the midpoint of our guidance. Our core portfolio is 95% leased, which represents a 130 basis point increase year-over-year. Our Defense/IT segment is 96.8% leased which is the highest level since we began disclosing the segment in 2015 and represents a 190 basis point year-over-year increase. Same property cash NOI increased 5.8% over the second quarter of last year and increased 7% during the first half of the year. We executed 88,000 square feet of vacancy leasing with a weighted average lease term of nearly 7 years, which brought our total for the 6 months ended to 187,000 square feet.

Adding the first few weeks of July, we've executed 218,000 square feet of vacancy leasing year-to-date, which puts us right on track to achieve our full year target of 400,000 square feet. Recall, our expected vacancy leasing volumes in 2023 are lower than 2022 due to the diminished inventory available for lease in our defense locations.

The National Business Park is now 99.3% leased, which represents a 550 basis point increase since the end of last June, with only 31,000 square feet of unleased space in the 4.1 million square foot park, and the largest vacant space is only 7,800 square feet.

In our Defense/IT portfolio, we have 670,000 square feet of inventory available which is the lowest level since 2017, despite the fact that the portfolio has increased by nearly 6 million square feet during that period.

Our overall portfolio leasing activity ratio remains strong at 75% with a pipeline of 915,000 square feet of vacancy prospects. Total leasing volume of 891,000 square feet in the quarter included 803,000 square feet of renewals. Our overall retention rate for the quarter was 89% with our Defense/IT locations at 93%. And year-to-date, our overall retention rate is 83%. Cash rent spreads were up 1.3% for the quarter, while GAAP rent spreads were up 7.4%, driven by annual rent increases of 2.6% with a weighted average lease term of 5 years.

Year-to-date, rent spreads are up 1.1% on a cash basis and 6.9% on a GAAP basis with a weighted average lease term of 4.5 years. Measuring the starting cash rent of the tenant's expiring lease to the starting cash rent of the renewal lease. The annual compound growth rate achieved on these leases was 3.4% for both the quarter and year-to-date.

On Page 22 of our flip book, we expanded our large lease disclosure to include our view of renewals through 2025, and we continue to expect portfolio retention to be extremely strong.

Looking forward over the next 10 quarters, we have 7.1 million square feet of leases expiring, which includes 3.9 million square feet of large leases defined as leases over 50,000 square feet. We expect a retention rate of roughly 95% on these large leases.

For the balance of 2023, we expect to renew 100% of the large leases that are included in this total. Our 1.5 million square feet of active developments are 92% leased, with a total estimated cost of $480 million and consisting of 9 projects located in Maryland, Northern Virginia and Huntsville, Alabama. We expect to place 800,000 square feet of developments into service over the remainder of 2023 that we expect to be 99% leased when delivered. During the first 6 months of the year, we executed 495,000 square feet of development leases, including 3 full building build-to-suits and 30,000 square feet of development lease-up.

Our development pipeline, which we find as opportunities we consider 50% likely to win or better within 2 years or less, currently stands at 1 million square feet up from 700,000 square feet last quarter. Beyond that, we're tracking another 1.2 million square feet of potential future opportunities, which should allow us to maintain a solid development pipeline in the near and medium term. With the National Business Park essentially full, we are in the planning stage for our next contractor and government buildings, and have commenced predevelopment and pre-leasing activities.

We remain confident in achieving our 700,000 square foot development leasing goal for the year. The success we've achieved during the first 6 months of the year has compelled us to increase the projected midpoint for FFO per share, and we remain confident we can achieve our FFO per share growth expectations through 2026.

And with that, I'll hand the call over to Anthony.

[Anthony Mifsud, executive]

Thank you, Steve. We reported second quarter FFO per share as adjusted for comparability of $0.60, which is $0.02 higher than the midpoint of our guidance. The quarter's outperformance was primarily driven by lower-than-expected net operating expenses, a portion of which was the timing of certain repairs and maintenance projects that we now expect to be completed in the second half of the year and slightly lower interest expense.

We have generated very strong increases in same-property cash NOI with the results that have exceeded our initial expectations. Driven by the year-to-date outperformance that is not timing-related, we are increasing the midpoint of our same-property cash NOI guidance by 100 basis points to a revised range of 4.5% to 5.5%. This represents a 200 basis point increase in the midpoint for same-property cash NOI growth from our initial guidance target.

Same property occupancy ended the quarter at 92.8%, which is up 70 basis points sequentially from last quarter and up 170 basis points year-over-year, and we expect occupancy to continue to increase throughout the remainder of the year as executed leases commence, including 70,000 square feet by Lockheed Martin at 1200 Redstone Gateway in the third quarter, after taking occupancy of 52,000 square feet in the second quarter and 70,000 square feet in our Fort Meade/BW Corridor subsegment during the third quarter.

Our core portfolio is 95% leased with our Defense/IT locations finishing the quarter at 96.8% leased. Our 3 largest concentrated defense locations, which consist of the National Business Park, Redstone Gateway in Huntsville, and Lackland Air Force Base in San Antonio are 98.8% leased in aggregate and account for roughly 45% of our core annualized rental revenue. Adding our fully leased data center shell portfolio 50% of our core annualized rental revenues are generated from assets that are 99.3% leased. The strength of these properties occupancy, operations and cash flows are emblematic of our Defense/IT portfolio.

Year-to-date, we have renewed 997,000 square feet with cash rent spreads up 1.1%. Based on our performance year-to-date and lease negotiations underway, we are increasing the midpoint of our cash rent spread guidance by 50 basis points to a revised range of flat to up 1%.

Our balance sheet is well positioned to navigate the current volatility in the capital markets environment. We have no significant debt maturities until March 2026. Our unencumbered portfolio now represents 96% of total NOI from real estate operations. Additionally, at the end of the quarter, we had over 70% of the capacity on our line of credit available.

Our variable rate debt exposure was just under 5% at quarter end. Although we expect our floating rate debt to increase slightly over the remainder of the year as we fund development on our line of credit, our projections continue to have it below 10% at year-end.

Turning to 2023 guidance. Given our outperformance for the first 6 months of the year, we are increasing the midpoint of our FFO per share guidance by $0.02 from $2.38 to $2.40.

This revised midpoint represents a 2% increase in FFO per share over 2022's results. For the third quarter, we are establishing a guidance range for FFO as adjusted for comparability of $0.59 to $0.61 per share. The resulting guidance for the fourth quarter implies FFO per share between $0.60 and $0.62. With that, I'll hand the call back to Steve.

[Stephen E. Budorick, executive]

Thank you. Summarizing our key messages. We delivered another strong quarter with FFO per share $0.02 above the midpoint of our guidance. Our Defense/IT segment is 96.8% leased, the highest rate since we started reporting the segment in 2015. We raised the midpoint of full year same property cash NOI guidance by 100 basis points driven by a great first half. We're on track to achieve our full year goals for vacancy and development leasing. Our 1.5 million square feet of active developments, which are 92% leased, provide a strong trajectory for NOI growth over the next few years. Our liquidity is very strong, and we continue to expect to self-fund the equity component of our expected development investment going forward.

We raised the midpoint full year FFO per share guidance by $0.02 and now expect to deliver FFO per share growth of 2% in 2023, 1% higher than our initial expectations. And we continue to expect compound annual FFO per share growth of roughly 4% between 2023 and 2026 from the midpoint of our original 2023 guidance.

Before wrapping up the call, I wanted to share some interesting current perspectives. Agencies within the U.S. government have become increasingly vocal about the cyber espionage threats to our country. On last quarter's call, we shared the threat assessment published by the Director of the National Intelligence or DNI, regarding China. More recently, the office of the DNI advised Congress that Russia is focused on improving its ability to attack our infrastructure networks and China is likely capable of attacks that could disrupt our infrastructure. This quarter, The Five Eyes, which are the intelligence operations of the United States, United Kingdom, Canada, Australia and New Zealand just issued a warning that a Chinese state sponsor entity has targeted networks across critical U.S. infrastructure sectors.

And last week, reports emerged that China-based hackers infiltrated e-mail accounts at the State Department and the Department of Commerce. The Center for Strategic and International Studies or CISC maintains a log of significant cyber events that have occurred since 2006, defined as state actions espionage and cyber attacks, where losses exceeded $1 million.

Since 2010, when the U.S. Cyber Command was established, the number of annual significant cyber incidents, CISC has reported globally, has escalated at a compound annual rate of 16% and has averaged 11 significant cyber attacks per month over the past 36 months.

Our government's reaction to these threats has resulted in increased cyber-related investments, which has led to increased demand for our portfolio and our record level of leased inventory. Our portfolio is well positioned to continue to benefit from this investment given our advantaged locations and expertise in providing secure space. Year-to-date, over 50% of our executed vacancy leasing supports cyber activities, primarily in the Fort Meade/BW Corridor.

Over the past 3 years, we've completed 730,000 square feet of cyber leasing in both our development and operating portfolios. Today, we have 465,000 square feet of demand seeking new and expansion space requiring SCIF or secure facilities, primarily to support cyber mission growth.

The National Business Park is 99.3% leased, the highest level in the past 15 years, and we're preparing new development options, primarily to support cyber mission growth for both the U.S. government and defense contractors.

These facilities will require security enhancements and they'll address the asymmetric cyber threat that will persist indefinitely, thus, deepening the durability of our unique property portfolio and the resulting cash flows. We're extremely proud to have played an important role in providing valuable leases to our cyber tenants, and we look forward to the inherent expansion opportunities that will emerge from the critical defense needs of our country. So operator, with that, please open up the call for questions.

[Operator]

[Operator Instructions] And I show our first question comes from the line of Blaine Heck from Wells Fargo.

[Blaine Heck, analyst]

Maybe just a high-level question to start out. The government accountability office just did a study on federal buildings that -- concluded that the utilization at those buildings was very low. Obviously, the study covered a much different set of assets than what OFC owns. But can you just talk about your portfolio and how you'd characterize the utilization amongst your U.S. government tenants?

[Stephen E. Budorick, executive]

Sure. So first, let me talk to that study, which we read that primarily deals with the GSA -- the large GSA leases within the beltway. And indeed, they are very lightly used. Some estimates are 20% or less. And they've allowed a lot of work from home, and that employee base has gotten pretty comfortable with that arrangement. I've also learned that there are 15 separate labor unions that represent the various U.S. government employee bases and the kind of return-to-work efforts are going to take a long time because of the fractional representation of those employees.

But turning to our portfolio, our government customer assets are not included in that report. Our government customers predominantly are in the defense or intelligence community. And because of the security requirements of their mission work, they are required to work in the office. So really going all the way back to October of 2020, the attendance in our government leased buildings has been normal or full, and it just doesn't pertain to our portfolio.

[Blaine Heck, analyst]

Great. Steve. And then switching gears a little bit to the data centers. Power issues have become an impediment that we talked about consistently in the Northern Virginia data center business. Do you see those power issues subsiding at any point? And if not, I guess, would you consider developing data centers in any other market if your customer was willing to kind of plant a flag elsewhere?

[Stephen E. Budorick, executive]

So let me deal with the power, and I'm not exactly an expert, what's happening there. But the 2 power companies in Northern Virginia are working to increase the overall power capacity. And our understanding is it's going to deliver in roughly 1/3 in '24, '25 and '26. So I think we're more than 12 months away from seeing new power supply that can be pushed through the local distribution network. With regard to our appetite to follow our customer to a new market, we absolutely would do that provided the market was a substantial data center market with long-term confidence in assurance of a high demand level.

[Operator]

And I show our next question comes from the line of Michael Griffin from Citi.

[Michael Griffin, analyst]

Maybe just touching again on the leasing front. I appreciate the disclosure around the large lease renewals through 2025. And you talked about 95% of these, about $4 million expected to be renewed. But for the remainder of that $7 million that expire, what should we expect in terms of retention rates? And any color you can give around that would be helpful.

[Stephen E. Budorick, executive]

Sure. So we're not going to put out a statistical number, but it's extremely strong, Griff. We expect very little nonrenewal in our portfolio. So I would say if you just handicapped the rest of it at, call it, roughly 80%, we'd be at or maybe better than that.

[Michael Griffin, analyst]

Great. And then I know a topic that's been coming in for the past with Redstone is the potential moving of space demand from Colorado there. I'm curious if you can give any update on timing or anything around that matter.

[Stephen E. Budorick, executive]

Well, I wish I had one, but I don't. For those people that are less familiar, Space Command was through a process, identified Redstone Gateway as the best location to stand up this new combatant command. There's been a lot of politics in the Senate level in the house where other states have protested the decision. They've gone through a reassessment twice in all 3 cases. Redstone Gateway has been the prevailing selection. It seems to be in a politically charged environment where the final decisions not been made and we continue to await the outcome as a lot of people in Redstone Gateway.

[Operator]

And I show our next question comes from the line of Camille Bonnel from Bank of America.

[Jing Xian Tan, analyst]

Anthony, could you please share the latest thoughts on how the company is thinking about its payout ratio? As we head towards the second half of the year, it looks like AFFO will be improving, implying your payout ratio will trend towards low 60%. So what's the sweet spot for you? And does the company have a target for the medium term?

[Anthony Mifsud, executive]

Our target for our payout ratio of AFFO has always been in the 70% range. Our projection for this year is that for the full year, we'll be more in the mid-60s of our total payout ratio based off of our remaining improvement -- our results for the year and the remaining improvements that we expect to make to our properties. So our ratio has always sort of been in that sort of 65% to 70% range.

[Jing Xian Tan, analyst]

Okay. Great. And on the operating expense side, it looked like it outperformed in the quarter, but operating margins went down slightly. Was that more onetime in nature?

[Anthony Mifsud, executive]

It was. I think there's -- operating expenses were favorable for the quarter. Some of that related to some R&M projects that were -- the completion of which were pushed into the third and fourth quarter of this year. But there was really no -- sort of noise around our margins.

[Jing Xian Tan, analyst]

Okay. So you expect to see that improving from here?

[Anthony Mifsud, executive]

Yes.

[Operator]

And our next question comes from the line of Tom Catherwood from BTIG.

[William Catherwood, analyst]

Steve, maybe going over to the vacancy leasing pipeline. Could you provide some more color around that? And specifically thinking are there certain regions of yours that are stronger than others? And what's really driving some of these tenant requirements? Is it expirations, expansions? Is it winning new contracts? Are there some kind of general themes that you can pull out of the demand that you're seeing?

[Stephen E. Budorick, executive]

Sure. So I would say probably the 2 strongest areas in the development pipeline -- well, it's more than 2. But collectively, the BW/Fort Meade Corridor is extremely strong. And I spoke a little bit to the amount of tenant demand for new or expanded SCIF capacity in the BW market. And that is heavily aligned with or associated with new contracts and expanded opportunities in that cyber-related activity that I closed my comments with. The other area is Northern Virginia and again, most of that demand includes a need for expansion of SCIF because of expansion opportunity -- or new contract and expansion opportunities in the Route 28 corridor.

[William Catherwood, analyst]

So when you're talking about the increased SCIF, is that -- is the cost for that base building? Is the cost for that covered in TIs? Are the tenants putting in -- when you look at those leases is on a net effective basis, is that more beneficial to you? Or just over the long term, does it make the tenant stickier?

[Stephen E. Budorick, executive]

So on the going in lease, we give a market level of tenant improvement. So some better or worse than a non-SCIF tenant but the tenant itself has to invest the incremental capital to complete the SCIF. And with the escalation in costs that have occurred, you'll have to budget at least $150 a foot, if not $200 a square foot to complete the SCIF component of that suite. So that heavy co-investment and the fact that SCIFs are not portable. You can't pick them up and move them to a new building is a major factor in our record or industry-leading retention rates. So it does accrue to our benefit over the long term.

[William Catherwood, analyst]

Got it. And then just with all the talk around increased demand, expansion of tenants, expansion of government budgets, what are you seeing in terms of new entrants in your specific area, providing real estate solutions to these tenants? And are you seeing any uptick in competitive supply?

[Stephen E. Budorick, executive]

We really haven't, Tom. We tend to dominate the market in and around Fort Meade. I will say with the extremely high level of inventory leased at the NBP, we're kind of guiding some of that demand into Columbia Gateway. And we've got a rapidly escalating kind of inventory of SCIF or SCIF demand in the park, which is really good for that portfolio long term.

In Northern Virginia, it's always Route 28 corridors being more competitive for us because there are multiple landlords. But there are certainly no new entrants, no new development and the inventory in and around the demand drivers is largely well leased and stable. And of course, if you jump to Alabama, we have the best location period and the incremental demand tends to come to us.

[Operator]

[Operator Instructions] And I show our next question comes from the line of Jay Poskitt from Evercore ISI.

[James Poskitt, analyst]

I'm just curious what you have baked into guidance in the back half of the year from a macroeconomic perspective. I know you mentioned that interest expense came in a bit better than you expected. So just curious your thoughts for the macro environment and also the rate environment in the back half of the year.

[Anthony Mifsud, executive]

So from a rate environment built into our forecast for the balance of the year is the current SOFR curve that came -- that is sort of the most immediate one after the impact of any changes from the most recent Fed increase earlier this week. So it has the current projections for where the market is. I'd say a 25 basis point change in that curve for the remaining 6 months of the year is only about a $200,000 increase in interest expense for the 6 months ended just because such a large portion of our debt is fixed at this point, fixed or swapped.

[James Poskitt, analyst]

That's helpful. And then just was wondering if there's any update on the regional office leasing activity?

[Stephen E. Budorick, executive]

Well, so our leasing activity ratio for the regional -- the 5 regional office assets is about 68%. But I will say it's largely preliminary opportunities except for a lease that we're competing for in Downtown D.C. for 2100 L. So there's sharp contrast between the timing and the sense of urgency and the demand in our defense business, which is over 90% of our revenue and that 10%, which is regional office, it's pretty lethargic and I would not look for meaningful progress in the leasing environment through the end of the year with the exception of the 1 lease we're competing for at 2100 L.

[Operator]

Thank you. I'm showing no further questions in the queue at this time. I'll now turn the call back to Mr. Budorick for closing remarks.

[Stephen E. Budorick, executive]

Well, thank you all for joining us today. We are in our office, so please coordinate through Venkat, if you would like a follow-up call. And thanks again for joining us.

[Operator]

Thank you for your participation today in the Corporate Office Properties Trust Second Quarter 2023 Results Conference Call. This concludes the presentation. You may now disconnect. Good day.